Trading can be divided into three main categories of expertise: strategy, management, and discipline. Put another way: decision, risk management, and willpower. These three elements are the only things you will be able to control in the market. The public loves to emphasize strategy in all its glamour and prowess. Strategy is essentially your reason for entering and exiting the market. What conditions need to exist for you to want to buy and sell? In its most basic form, strategy is our means of making decisions consistently. Some people don’t use a strategy in the market, leading to unsustainable practices. A common example of this is trading on a whim.
Strategy is the minimum prerequisite for being a successful trader as it defines the way you make decisions in a consistent and concrete way. But strategy alone will NOT make you successful. Having a strategy in the market will take you from being a financial idiot, to a trading amateur.
Well if it is necessary then why am I undermining it? The reason is that strategy is a tiny part of your overall plan. The most important part of a trading plan is not the strategy, but the management. Mastering Risk and Money management will help you tremendously more as a trader than any strategy. Management is the skill of losing. You are essentially getting very good at taking losses. The trick is to take tiny loses so that your account is still there when it is time to bank a profit.
Warren Buffett’s first rule of investing is capital preservation. Learn to keep your money before you learn to make money. People are attracted to the ‘get rich quick’ aspect of markets. It is easy to make a 100% return in the market. All you have to do is over-leverage your entire account, take massive risks, cross your fingers, and hope your right.
The crazy part is you may in fact be right and double your account in a matter of days. It is hard to understand that this is an illusion. It is not sustainable. You cannot consistently do this, because you will eventually wipe out your funds. That is the entire point of risk management: to ensure that you are risking enough per trade so that you can live to see another day in the market. Trading is a long-term endeavour. The more emphasis you place on the individual trade, the more likely you are to screw up. Learn to see the big picture of your trading goals.
So if I have strategy and risk management I will be a successful trader, right? No. These are the tangible elements of any good trading plan. Decide when to enter and exit, and how much to risk when you do. But there is an intangible element to successful trading that is hard to teach and essential to have in order to win: Discipline. Discipline will make or break a trader. Basically, discipline is your ability to stick to your plan. If your plan consists of your strategy and risk management, then discipline is having the resolve to listen to the plan and take trades according to it at all times.
You probably think this is obvious. Why would anyone spend hours devising a strategy just to not follow it? The answer is summed up in two words: greed and boredom.
Imagine sitting in front of a price chart. According to your strategy, you will buy into the market when you see an uptrend. You will also wait for a low volatility state in the market. To ensure you are here to see another day, you decide to only risk 2% of your account on each trade. So if you are wrong on this trade, you only take a 2% loss.
Strategy: Buy when there is an uptrend and Low Volatility
Management: Risk 2% of equity
So this is your plan. It’s simple and easy to follow. What could possibly go wrong?
Enter Boredom and Greed
Turns out the strategy you created very rarely has open signals to enter the market, so you find yourself sitting on your hands a lot and waiting. But you want to be a trader! All the bright flashing lights of the market are in front of you and you just want to get in. The market is luring you in. Then all of a sudden you see a chart pattern form that you read about once in a book. You say, ‘Sweet, this looks like a killer trade! Even though it’s not in my plan, I know it’ll work.’ So you find yourself in a trade that you were not prepared for. Sometimes it will work and you will, in fact, make money, but the point is that you lost your discipline. You didn’t follow the plan. You were bored and wanted to make trades because sitting around all day was getting annoying; you got greedy and tried to do more than what you had been planning for.
Mistake #1: Overtrading
Trading out of boredom is essentially the same as taking drugs. You are addicted to the flashing lights and have lost sight of the reason we trade. Trading is an activity of making money. Trading just to get a rush has the nasty tendency, like drugs, of leaving you wanting more. So you make more trades and take more risks. Before you know it, you’re living behind a dumpster eating yesterday’s croissants.
Mistake #2: Not following the plan
You are not better or smarter than the market. The only way to consistently profit off the market is to have a battle plan. It will make your decisions faster and sharper. Plan the trade and trade the plan.
Discipline is the hallmark of pro traders. It is a developed skill. So start small and build up your discipline. Create a habit and stick to it. A tiny habit. Instead of saying you will floss your teeth once a day, start smaller and only floss one tooth a day. Just one tooth and you are done for the day. Then next week add one more tooth. Stick to it. By the end of the year you will be a regular flossing citizen! The point of the exercise is to show yourself that you can in fact develop a plan and stick to it.
Self discipline is perhaps one of the hardest things we must learn in our lives. Don’t smoke. Don’t eat that muffin. Go to the gym. Eat a salad. Write that essay today. Floss! Without discipline, we would be incapable of delaying life’s daily pleasures in the name of real satisfaction. Without discipline we would live like impulsive instant-gratifiers. Maybe that’s okay in life, but instant gratification in markets will lead to instant demise.